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2008 Winter Midterm #2

Midterm #2 Economics 102 Winter 2008


For grading, each identification is weighted equally.

Identify the following terms. Time should not be a constraint, but don't therefore simply write and write. To keep you from being unduly concise, I put subpoints under each to help you structure your answer. (At least two truly are multipart.)

  1. What does the term mean?
  2. What model(s) is it tied to or how is it otherwise used?
  3. So what?
  4. What of it empirically? (Not relevant for some IDs.…)

1. Saving.
A. Motives.

Saving is cutting C in one period in order to increase it in another, serving about all to smooth consumption over time. (In our macro model, S = Y - C - T) There is thus:

  1. precautionary saving and
  2. retirement saving as well as
  3. inventory saving (since income isn't received daily...). Finally there is
  4. target saving for big lump-sum items (house down payment, child's tuition) when consumption is anomalously high.

Note that saving is not motivated by interest rates. Most savings is types (ii) and (iv) for specific goals. When returns are high, you can save less and still achieve those goals (in micro terms, an income effect). Empirically this offsets substitution effect from higher returns, so that on net savings is unchanged.

B. Models.

The primary model is the lifecycle model of Ando Modigliani (which is similar to the permanent income model of Milton Friedman). As we developed the model,  we note that on average income changes in a predictable pattern over a person's life cycle, but there is no particular reason to think that we don't prefer a steady level of consumption (certain lump-sum expenditures aside). We would like to dis-save while we are young (financial markets may not let us) and to maintain consumption when our income drops after retirement. So we save duing the middle period of our life.

C. Policy implications.

Above all, savings partially offsets short-term swings in the economy. Unfortunately that includes those due to short-term policy changes. Hence it's likely that 60% of the stimulus package will be saved, not spent, lessening the ability to boost the economy. Similarly, during a recession consumption falls less than income; people dip into savings to smooth consumption over what they hope will be a short-term blip in their careers.

A second, subsidiary aspect is that savings will vary with the age composition of the population. A very young population (the case of any society in which population growth is high) will tend to save less, as will a very old society. Similarly, savings will tend to rise if there is an on-going growth spurt. This occurred in post-WWII Italy and Japan, and more recently in Korea and now China; all showed very high savings rates.

2. Investment.

A. What is it.

Investment is the purchase of new productive resources, in the form of plant, equipment and software, business structures and new housing (for accounting purposes there is also the minor item of inventory adjustments). "I" is about 15% of GDP, but matters more because swings in investment are the proximate cause of most swings in the overall growth of the economy.

B. Models.

I = I(E(g), i)

In principle it seems that investment should reflect the end result of a rational planning process, in which businesses forecast net revenue for a given project, appropriately discounted, and compare that with the up-front cost. For discounting they can use the opportunity cost of money, in effect asking how much money they would need to put in the bank to obtain, given compounding, the same amount of money in year X as the investment is projected to generate.

In practice the projections underlying investment planning hinge upon many intangibles, and so relies in the end upon the judgment of senior management, the "animal spirits" of investors including (in the example we used in class) the Superbowl Effect. Such expectations of growth E(g) dominate interest rate considerations; interest rates in practice have almost no empirical impact on business investment.

In contrast, a person building a house needs a mortgage, and the cost of that is directly affected by interest rates. So housing investment is sensitive to interest rates (as more generally is consumer durable consumption, which is counted as part of C).

C. Policy implications / other aspects.

If we can affect interest rates, then we can have an impact on investment behavior, but primarily through the new housing channel. That is about 1/3 of total I so it can have a modest impact, but it is hard to use it to offset a drop in business I. If we knew how to affect expectations …. but we don't, though the overall fiscal and monetary policy stance of the government can certainly help.

3. What factors influence foreign exchange rates?

A. If US interest rates decline, what should that do to the value of the US$?

If i in the US falls, ceteris paribus, then demand for US$ will fall and the supply of US$ to purchase other currencies that now pay relatively more interest will rise. (In a graph, D shifts in, S shifts out.) The net effect is a depreciation of the US$, where one dollar buys less of other currencies.

B. If sovereign wealth funds diversify, what should that do to the US$?

To date most countries have held all of their foreign exchange reserves in US treasuries. SWFs have been set up to diversify these portfolios, including via the purchase of non-US$ assets. The impact should thus be lower demand for the US$ and (again) a depreciation of the US$.


C. How in turn would the shift(s) you identify affect the US economy?

The depreciation of the US$ makes imports more expensive and causes them to decline, while making exports cheaper for others to buy causing exports to rise. As a result (X-M) should rise, boosted by the multiplier effect, and thereby bolster growth of the US economy. However, a weaker dollar also tends to cause a rise in inflation, since imported goods are more expensive.

4. Multiplier. You do NOT need to put in formulae - focus on concepts.

A. Nature of it.

The multiplier represents a feedback effect that amplifies the impact of an increase in I, G, X or T (transfers). In effect an exogenous increase in GDP (Y) causes a rise in incomes which, net of various leakages (savings, taxes, imports) in turn increases C and hence Y. But this again increases incomes … multiplying the initial impact. Of course a decrease in (say) I is multiplied in the same manner, amplifying the decline in Y.

B. Use of it.

In the US context, the value of the multiplier is about 1.5 (our simple model gives a value of 2 but incorporating more types of changes diminishes the value somewhat). That means for example that the impact of a permanent tax cut is greater than the dollar amount suggests. However, one-shot policies that are perceived as such interact with savings behavior in a manner that mutes the multiplier effect (see savings above!!).

C. Policy implications / other aspects.

This is one of many potential examples of the feedback effects and interactions that distinguish macroeconomics from microeconomics. You can't simply assume the initial impact of a policy change is the end of the story. The multiplier model also helps explain why individual states in the US (and small countries in the EU) don't engage in fiscal policy, because imports are a large share of the economies so that the multiplier is very small. In effect, neighboring states (countries) would accrue most of the benefits. In the EU however there is as yet no institutional mechanism for coordinating the economic policies individual members to overcome this barrier; the central government of the EU is very weak (cf. the Articles of Confederation in the initial days of US independence).

5. Real vs nominal.

A. Explain the distinction.

Nominal is simply counting things up in current dollars or values. However, because prices change across time (inflation π), these values are misleading. For example, because of inflation, nominal growth rates are higher than "real" rates that try to hold purchasing power constant. Similarly, part of a nominal wage increase is offset by inflation, as is part of nominal interest rates. Since we care about the amount we consume, not the dollar value of what we consume, we need to be able to convert nominal values to real ones.

B. Give a representative calculation. (Make up numbers!)

Current year-on-year inflation for January is 4.3% = π. Current short-term interest rates are 3.0% = nominal i. Hence real i = nominal i - π = 3.0 - 4.2 = -1.3% (yes, negative). The purchasing power of a dolalr is eroding faster than what deposits earn.

Similarly, in February wages were up 5¢ over January's 17.75 level. Assuming this continues for a whole year, wages will rise 60¢ or 3.3%. Hence real wages are rising by: 3.3%-4.2% = -0.9%. That is, real wages are in fact falling.

Note that 3-month inflation rates are 6.8%, considerably worse than the annual rate as higher food prices and energy prices are taking a bite. Hopefully the latter is transitory, not feeding through into other prices so that the inflation rate is lower once the impact of the initial hike is eliminated. In fact, inflation not including energy and food is 2.5% year-on-year and an only slightly higher 3.1% over the past 3 months.

C. So what.

The above example should suffice -- we care about real variables (quantities) not nominal ones; in general, we assume we don't suffer from money illusion. Hence we need to calculate real variables, as the nominal ones can provide a misleading picture whenever there is a time component so that inflation matters.

6. Uh, actually, 5 is enough to show whether you have studied effectively and are comprehending the material. In other words, despite advance advertising, this is only a 5-question quiz.